Fed lesson: Beware the conventional wisdom

The transcripts of Federal Reserve Board of Governors meetings during the Panic of 2008 have been released and the news stories about them make for riveting reading. With the government allowing the failure of Lehman Brothers and the world financial system on the brink, many leaders of the central bank failed to grasp the magnitude of the catastrophe.

Most thought the economy would continue growing, even though we were well into the collapse of not merely the subprime loan market but the entire housing sector, even though more than a year earlier the trouble at Bear Stearns involving collateralized debt obligations had caused an ominous shudder through the markets and the banking system. Even so, the Fed refused to lower interest rates and some governors even wanted to raise them.

Fortunately for all of us, this dreamwalk didn’t last long. Chairman Ben Bernanke, our foremost scholar of the central bank in the Great Depression, was more concerned than most of his colleagues. Current Chairwoman Janet Yellen, then vice chair, was the earliest to grasp the magnitude of the danger and need for action.

The precise actions of the Fed, the bailout of AIG and that the banksters got away with it are things my column have picked apart and, in many cases, lamented. But had the central bank not lowered rates, flooded the system with dollars, become the world’s lender of last resort and undertaken extraordinary measures such as quantitative easing, we would have ended up in a Second Great Depression.

How could so many smart people have been so wrong?

Much of it has to do with the tyranny of the conventional wisdom. Huge banks, exotic financial instruments and deregulation were supposed to make the system safer. “Everyone” knew that. “Free markets policed themselves.” The economists and financial journalists that questioned this and raised early alarms were dismissed (sometimes quite literally).

Of course, the reality was quite different: This was a classic — if gigantic — speculative bubble driven by feral greed. It was made more dangerous by the interlocking nature of the global financial system and the speed at which it worked. Also, derivatives and other “financial weapons of mass destruction,” as Warren Buffett called them, that nobody really understood.

In the early 1930s, “everybody” knew that the proper response to events such as the 1929 stock crash and resulting contraction was to tighten belts, balance budgets, raise interest rates and, most of all, stay on the gold standard. Andrew Mellon, Treasury Secretary for the tragic Herbert Hoover, put it this way (according to Hoover): “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”

Not for nothing did a return to 1920s-style deregulation right down to the repeal of Glass-Steagall, happen after the causes of the Great Depression had passed from living memory. The widespread cluelessness was abetted by more than 20 years of stability, with decent growth, low inflation and mild recessions. Smart people talked of the “end of the business cycle.”

Other reasons why the Fed slept this time are as important. Regulators and Congress were compromised by the vast sums spent by banks on lobbying. So were many academics. The “financial services industry” surpassed manufacturing and a sales culture pervaded American life.

This time we were lucky, sort of. The worst was averted. But “financial services” remains potently dangerous — some of the latest bubbles growing include student loans and securitization of rents from houses bought by private equity. Many are suspicious as to whether Dodd-Frank, so complex, so twisted in knots by bank lobbying, could avert another collapse. The shadow banking system is out there…ticking…especially in China.

The Great Depression left a lasting mark on the nation, from the relative thrift of a generation that had been adults then to the government powers that helped the Bush and Obama administrations avert the worst this time. This lesser depression’s legacy is harder to gauge. There has been no virtuous “great reset.” Consumer borrowing leaped in the fourth quarter despite stagnant wages. Our infrastructure remains largely inadequate. Are people more cautious about the conventional wisdom?

The Fed learned that it could do “whatever it took,” as Bernanke put it, to avert the sum of all fears. Winding it down will be another matter.